Judicial resistance to the IRS's growing power with the clear reflection standard.

In the November-December 1992 issue of The Tax Executive, Gregory A. Carnes and Ted D. Englebrecht wrote about "The Internal Revenue Service's Increasing Power with the Clear Reflection of Income Standard." This thoughtful article stimulated my thinking because it documented the IRS's increasingly bold campaign in this area as well as the ambiguity and complexity that accompany increased emphasis on income timing rules. Carnes and Englebrecht suggest that resort to the legislature may be necessary to retard the IRS's movement away from generally accepted accounting principles (GAAP).

Carnes and Englebrecht focused on recent inventory valuation cases. The IRS, however, has attempted to use the clear reflection standard to attempt to override a tax accounting rule in a variety of other situations, including long-term contract. Moreover, although the cases analyzed by Carnes and Englebrecht definitely mark a trend, the courts have generally resisted IRS efforts to override a statutory or regulatory accounting rule even where the IRS concludes that the taxpayer's method does not clearly reflect income. In the past several years, the courts (particularly the Tax Court) have applied this common sense limit in a variety of situations. This article focuses on the circumstances in which taxpayers have successfully argued that the IRS has erred in not following a statutory or regulatory accounting rule.

I. All-Events Test-Expense

In a 1992 case, the IRS attempted to override the all-events test of Treas. Reg. SS 1.446-1(c)(ii) in pursuit of its goal of "clearly reflecting income." In Fidelity Associates, Inc. v. Commissioner, T.C.M. 1992-142, the taxpayer used the accrual method of accounting for both tax and financial statement purposes. Book sale income was accrued as the books were shipped. The taxpayer, however, reported the related book sale commission expense differently for tax and financial accounting purposes. For financial accounting purposes, commissions paid were recorded as expenses at the same time as the book sale income - as the books were shipped; for tax purposes, the commissions were deducted when the orders were approved. The excess of paid commissions over the accrued commissions was shown as "prepaid" or "deferred" commissions on the company's financial statements.

The IRS conceded that the all-events test of the regulations had been met. (This concession is not surprising inasmuch as the commissions were not refundable even where the taxpayer could not collect the total contract price from the customer.) Nevertheless, the IRS challenged the deductibility of the commissions, advancing two arguments for its position. First, the IRS argued that section 446(a) of the Internal Revenue Code requires absolute conformity between taxable income and book income. Second, the IRS argued that the clear reflection of income standard of section 446(b) was violated because income and expenses were mismatched.

A. The Conformity Requirement

Section 446(a) provides that "[t]axable income shall be computed under the method of accounting on the basis of which the taxpayer regularly computes his income in keeping his books." If these words require absolute conformity, taxpayers would simply have to use the same method of accounting for tax and financial accounting purposes unless the IRS requires otherwise. According to Judge Gerber in Fidelity, this absolute conformity argument was "anomalous" because the IRS usually finds itself in a position of arguing that the taxpayer should be required to use a different method of accounting for tax purposes from the method used for book purposes.

Furthermore, the Tax Court observed that the IRS's proffered interpretation of "books" was inconsistent with Treas. Reg. [section] 1.446-1(a)(4), which states:

Accounting records include the taxpayer's regular

books of account and such other records and data as

may be necessary to support the entries on his books

of account and on his return, as for example, a

reconciliation of any differences between such books

and his return.

Such language, the court said, clearly implies the potential for variations between financial and tax reporting.

Finally, even the most widely cited case for the proposition of the IRS's discretion over accounting methods - Thor Power Tool Co. v. United States, 439 U.S. 522 (1979) - emphasizes the different objectives of tax and financial accounting. Indeed, the holding of Thor depends on the differentiation of such objectives.

In sum, the Tax Court held that a taxpayer can choose among accounting methods as long as three conditions are satisfied: the other requirements of the Code are met; the taxpayer's overall method is in conformity; and the taxpayer's method clearly reflects income.

B. "Clearly Reflects Income"

Since the basic requirements of accrual accounting under the all-events test were clearly met in Fidelity, the Tax Court was faced with the question whether the IRS should be permitted to override the test in order to clearly reflect income. After carefully considering the IRS's argument that the matching concept was violated by the taxpayer's treatment, the court held that the IRS had abused its discretion in attempting to upset the taxpayer's method of accounting.

In Fidelty, the IRS argued that an obvious mismatching occurred because income from book sales was accrued when the books were shipped but commissions were paid when the orders were received. The Tax Court agreed that some mismatching occurred, but rejected the idea that exact matching is required.(1) Thus, the court held that even though matching is a desired goal, it will not override an established tax accounting rule unless the distortion is more substantial than occurred in this case.(2) Although the Tax Court accorded the taxpayer considerable latitude in its choice of expense timing, the amounts at issue in Fidelity had in fact been paid and economic performance had occurred.(3) Citing Prabel v. Commissioner, 91 T.C. 1101, 1118 (1988), aff'd, 882 F.2d 820 (3d Cir. 1989), the court thus said this was not a case where accrued expenses "significantly exceed[ed]" the taxpayer's cash payment obligations and where the obligation to make payments consistent with the accrual was under the taxpayer's unilateral control.

II. All-Events Test-Income

The matching principle was also at issue in Orange & Rockland Utilities v. Commissioner, 86 T.C. 199 (1986), in which a utility deducted expenses related to services that, under its revenue recognition method, had not been included in income for tax purposes. Rather than taking issue with the taxpayer's expense accrual method, however, the IRS attempted to change the revenue recognition method.

In Orange & Rockland, the utility used the cycle meter reading method pursuant to which revenue generated for services furnished after the last cycle meter-reading date in December was not accrued until the next year; related expenses, however, were deducted as incurred. For financial statement purposes, the utility accrued the unbilled revenue for services furnished between the last cycle meter reading date in December and the end of the calendar year.

The Tax Court refused to disturb the taxpayer's income deferral method because it viewed the cycle meter-reading date as the critical event that fixed the taxpayer's right to receive unbilled December revenue. Until this date, under public utility commission regulations, the taxpayer was not entitled to bill nor pursue an enforceable right to the revenue. (In other words, this was not a situation where the taxpayer had manipulated its income recognition method to prevent the accrual of income.)

The IRS also raised the same conformity issue as in Fidelity, but the Tax Court responded that book/tax conformity could be required only where a method is "not specifically permitted." Since the cycle meter-reading method was in wide use in the utility industry and was in accord with GAAP, the court in Orange & Rockland was not willing to allow the IRS to override the all-events test. Neither conformity with financial accounting rules nor better matching of revenue and expense was sufficient to persuade the court to override the accounting rule.

III. Cash Basis

Under what circumstances might the Tax Court be receptive to the IRS's conformity argument? One such circumstance might be where the taxpayer is on the cash basis. In Applied Communications, Inc. v. Commissioner, T.C.M. (CCH) 1989-469, at 1479 (1989), Judge Gerber - who wrote the taxpayer - favorable decision in Fidelity - said "it seems incongruous for the petitioner to contend that the cash method of accounting more clearly reflects income (for tax purposes) and then represent its earnings under the accrual method of accounting to its shareholders and the public."

At its inception, Applied Communications, Inc., which was a custom computer software business, reported on the cash method for both financial and tax purposes. Initially, its income was derived mainly from services, but after two years it began selling hardware. The company continued to report its software-generated revenue on the cash basis, but reported its hardware income on the accrual basis for tax and financial purposes. Several years later, the company changed to the accrual method for software income, but for financial purposes only.

Thus, the taxpayer had consistently used the cash method for tax reporting of its software-generated revenue. Upon review, the Tax Court in Applied Communications required the taxpayer to conform its tax method to its financial method for two reasons. First, the court found that at about the same time the company had changed its financial accounting method of reporting software income, its business had been reoriented toward the development and sale of packaged rather than customized software. Thus, the movement from a service to product orientation took the edge off the taxpayer's argument that the cash method was proper for service businesses. Perhaps more important, the cash method in this situation was not in accordance with GAAP, SEC requirements, and loan contracts with creditors. Contrast this situation with Orange & Rockland where the taxpayer's method was in accord with GAAP.

The tax accounting issue at stake in Applied Communications is the availability of the cash method to taxpayers who are not affected by section 448 of the Code or a rule such as the prohibition of the cash method for taxpayers with inventories. Can the IRS override the otherwise allowable cash method in the interest of book/tax conformity or in the interest of clear reflection of income? The answer apparently depends heavily on the facts. For example, in Applied Communications the court cited the company's change from a service orientation to a product orientation, but then stated that the change was "obviously not a decisive factor." Nevertheless, in upholding the IRS's discretion to impose the GAAP rule in this situation, the court referred again to the change. At a minimum, though, the case does not stand for the proposition that a service taxpayer that keeps its books on the accrual basis is prohibited from using adjusting entries to convert to the cash basis for tax purposes.

IV. Long-Term Contract Severance

In Sierracin Corp. v. Commissioner, 90 T.C. 341 (1988), the Tax Court rebuffed an IRS effort to use its clear reflection power to sever a contract when to do so would have contravened one of the criteria in the regulations. The court thus held that the IRS could not require a manufacturer of highly customized window-type products used in aircraft and security situations to report gain or loss as each unit was delivered.

The IRS conceded the taxpayer's argument that it had a business purpose for treating an entire work order as a contractual unit. Nevertheless, the IRS said the work order should be severed by delivery "in order to clearly reflect income." Before turning to this specific issue, the court found it necessary to analyze the business-purpose criterion in Treas. Reg. [section] 1.451-3(e). Noting that separate deliveries were not independently priced, the court cited Example (2) under Treas. Reg. [section] 1.451-3(e), in which a shipbuilder contracted to build two submarines. Because it had not built this type of submarine before, separate treatment would have resulted in the first submarine producing little or no gain while the second would result in substantial profits. The ships, however, were obviously not independently priced. In such a situation, there is a clear business purpose for not severing the contract, and the court found the example in the regulations of relevance in Sierracin. In one of the company's divisions, the price of an order was based on the total quantity called for rather than the quantity shipped in any specific delivery. Separate pricing was nearly impossible, among other reasons, because the novel technology changed the costs over the lifetime of production.

The IRS in Sierracin attempted to override the business purpose criterion for severing a contract. In effect, the IRS wanted to invoke the clear reflection standard to prevent the deferral of income under long-term contracts. The regulations themselves, however, were presumably written with the purpose of furthering the clear reflection of income. In other words, the IRS'S attempt to limit the income deferral potential of allowable methods of long-term contract accounting ran headlong into a regulation whose purpose is the reporting of "real" rather than artificial results. The court effectively held that fragmenting a legitimate business agreement into parts that would not be negotiated on an individual basis would fly in the face of the clear reflection standard.

V. LIFO 

The IRS has obtained mixed results in trying to override the statutory right to use the last-in, first-out method (LIFO) of inventory accounting. Section 471 of the Code grants taxpayers the right to use LIFO, but section 472 gives the Commissioner authority to prescribe rules to ensure that the use of LIFO clearly reflects income. Because section 472 does not give the Commissioner the power to deny the use of LIFO, the Commissioner's activity in this area would appear to be limited to adjusting the rules. The Commissioner, however, has not taken such a circumscribed approach to the grant of authority in section 472 and, indeed, has proposed adjustments that can clearly be interpreted as denying the use of LIFO.

In a line of cases in the 1980s, the IRS tried to deny use of LIFO to users of the completed contract method (CCM), but the Tax Court rejected those efforts. In Peninsula v. Commissioner, 78 T.C. 1029 (1982), for example, the Tax Court sustained the simultaneous use of LIFO and the completed contract method. The IRS refused to follow Peninsula(4) and issued proposed regulations that specifically prohibited the tandem use of the LIFO/CCM combination.(5) Although the Claims Court held for the government in Spang Industries, 84-2 U.S.T.C. [paragraph] 9738 (Ct. Cl. 1984), the United States Court of Appeals for the Federal Circuit reversed, 791 F.2d 906 (Fed. Cir. 1984). In addition, the Tax Court subsequently affirmed its Peninsula decision in great detail in Reco Industries, Inc., 83 T.C. 912 (1984). In spite of its judicial defeats, the IRS issued final regulations (Treas. Reg. [section] 1.451-3(d)(8)) prohibiting precisely what the courts had allowed-the application of LIFO on an end-of-contract basis.6

In the LIFO/CCM cases, the IRS expressed concern that LIFO would over-defer income for a contractor using the completed contract method. The more this argument is pushed, however, the more it sounds like an attack on the theoretical underpinnings of LIFO itself. Thus, the IRS's complaint that LIFO/CCM results in deducting costs for contracts that have not yet been released into the income stream ignores the effect of LIFO on non-CCM contractors; they routinely deduct costs for unsold merchandise.

The IRS initially opposed LIFO in any form, but Congress removed this roadblock in the Revenue Act of 1939. The IRS then opposed the dollar-value method until it was judicially approved in Hutzler Brothers v. Commissioner, 8 T.C. 14 (1947). Since that case, the IRS has attempted to curb the benefits of dollar-value LIFO by narrowly defining pool or item within a pool. See generally Turner & Maples, Inventory Acquisition and Dollar-Value LIFO - The Effect of Bargain Purchases, 44 Tax Executive 103 (1992).

In Amity Leather Products v. Commissioner, 82 T.C. 726 (1984), the IRS succeeded in requiring separate pools for a company that both manufactured and purchased identical goods for resale. The company sold leather goods that it manufactured and sold identical goods that it regularly purchased from its subsidiary in Puerto Rico. The quality of the goods was similar, but the purchased Puerto Rico goods were bought at a substantially lower price. The Tax Court held that manufacturing and wholesaling/retailing should be separated for LIFO pooling purposes even though the parent exercised considerable control over the subsidiary.

If separate pools are required to distinguish between manufactured and regularly purchased goods, will a single isolated purchase also be treated as a separate pool? This question was answered in UFE v. Commissioner, 92 T.C. 1314 (1989). In that case, the taxpayer acquired all the assets of a business including inventory. This inventory was identical to the products subsequently manufactured by the taxpayer, though the purchased inventory had a significantly lower cost. The Tax Court held that such an isolated purchase did not make the taxpayer the kind of dual-function entity found in Amity. Thus, the taxpayer was allowed to combine manufactured and purchased goods into a single pool. In effect, the taxpayer was allowed to freeze the low-cost bulk purchase as beginning inventory and deduct the costs of subsequently produced goods, thereby serving "the overriding purpose of the LIFO regulations, which is to match current costs against current income."

This matching rationale, however, was not followed in Hamilton Industries v. Commissioner, 97 T.C. 120 (1991), a case virtually identical to UFE. There were apparently two reasons for the different result in Hamilton Industries. First, the bargain element was larger. Indeed, the court said the price paid for the inventory was "artificially low" and the entire bargain purchase was approximately equal to the minimum inventory required to operate the business. Second, the IRS argued that if the bulk purchase did not constitute a separate pool, it did comprise a separate item within a pool. (Under either the pool or the item argument, the effect was the same; the item is not double extended, thereby creating a FIFO-type of result.)

The Tax Court did qualify its decision in Hamilton Industries by suggesting that not all bargain purchases will create new items within a LIFO pool. The court will take a case-by-case approach in determining whether income is not clearly reflected. As a result, the door seems slightly ajar for the taxpayer to allocate a reasonable portion of a bargain price to inventory and freezing it as beginning inventory.

In summary, the Tax Court seems reluctant to allow the IRS to override the statutory right to use LIFO. In the long-term contract line of cases, the IRS's argument that the combination of LIFO with a long-term contract method over-defers income and thus does not clearly reflect income fell on deaf ears. The statutory right to use LIFO took precedence over the clear reflection standard. In the dollar-value-bargain purchase area, in contrast, the court clearly believes the benefits of LIFO should be denied taxpayers in certain extreme situations.

VI. Interest Bunching under

Consolidated Return Regulations

In Southern California Savings & Loan Ass'n, 95 T.C. 35 (1990), the Tax Court turned aside an IRS attempt to override a statutory accounting rule with a clear reflection argument. SoCal, a domestic building and loan association, filed consolidated returns with its affiliated group. On December 23, 1982, another affiliated group acquired SoCal. For the separate-return short year of December 23 through December 31, 1982, SoCal - which was a cash-basis taxpayer - deducted interest it paid or credited during the short period but that had accrued during the last six months of 1982. The IRS only allowed a deduction for the interest accrued during the short period.

Upon review, the Tax Court allowed the claimed deductions. The court pointed out that section 591 provides that a building and loan association may deduct amounts paid or credited to depositors as interest if such amounts are withdrawable on demand. Citing Hallmark Cards, Inc. v. Commissioner, 90 T.C. 26 (1988), the court said the IRS could not invoke the clear reflection standard to override a method of accounting that is specifically authorized in the Code and was applied on a consistent basis. In so ruling, the court may have been affected by the patent unreasonableness of the Commissioner's adjustment - pursuant to Treas. Reg. [section] 1.461-1(e)(3), the Commissioner proposed to allocate the disallowed interest over a ten-year period!(7)

The IRS cited section 461(e), the "anti-bunching" rule, in its effort to overcome section 591's explicit sanctioning of the cash basis. This provision was enacted in 1962 to prevent building and loan associations from postponing interest deductions into 1963 in order to offset higher taxable income caused by the Revenue Act of 1962. Section 461(e) provides that, except as provided in the regulations, amounts paid or credited as interest to depositors' accounts are not deductible for periods representing more than 12 months. In Treas. Reg. [section] 1.461-1(e)(1)(2), the IRS addressed the application of section 461(e) to short periods, providing that interest is not deductible for periods representing more than the number of months in the short period. In contrast, Treas. Reg. [section] 1.1502-76(b)(4) directs the taxpayer to allocate taxable income to its separate return in accordance with its permanent records. In SoCal, the court had to grapple with whether the consolidated regulations - which are clearly legislative regulations - preempt section 461(e) and the short-period regulations. The court concluded that they do.

SoCal is an unusual case in the context of this article, for it involves two accounting rules. Section 591 allows the cash basis for building and loan interest deductions and the Tax Court would not allow the IRS to override this accounting rule in the interest of clear reflection of income. At the same time, the Tax Court held that the consolidated regulations override the accounting rule of the section 461(e) regulations. Thus, although the IRS lost the case, it may have won a significant long-term victory in terms of the power of the consolidated regulations.(8)

VII. Perspective

On the whole, the Tax Court has not been sympathetic to IRS attempts to use the clear reflection standard to override a specific accounting rule. The all-events test has been respected in both income and expense situations where mismatching and lack of financial accounting conformity were obviously present. In the long-term contract area, the Tax Court would not authorize the IRS to override accounting rules to correct what the IRS felt was an over-deferral of income. Specifically, the court allowed the IRS neither to sever contracts in obvious violation of criteria in the regulations, nor to deny the use of LIFO to long-term contractors.

Concerning recent situations in which the IRS was allowed to override an accounting rule, it is difficult to discern any governing principles. Each case seems to be a special situation. For instance, one view of SoCal is that the IRS was able, through its regulations, to override a statutory accounting rule. The court, however, could not agree on how this statutory rule (an exception to the general rule) was to be interpreted. Thus, the majority of the court fell back to the general rule, which had support in the consolidated return regulations. The court then would not allow the IRS to override this general rule with a clear reflection argument.

As to the Hamilton Industries case, the taxpayer was clearly deprived of its statutory right to use LIFO. The large disparity between the purchase price and replacement cost, however, may have made the case a paradigm for the maxim" hard cases make bad law." The result in this case would appear to be less an erosion of the taxpayer's right to use LIFO than it is a correction of what the court saw as an extreme underallocation to inventory of the purchase price of a going concern.

The decision in Applied Communications is troublesome, not because of the result, but because of the ambiguity in the court's reasoning. The IRS was allowed to convert a taxpayer from the cash to the accrual method in order to clearly reflect income. But the only reason mentioned for requiring conformity to GAAP - the evolution from a service to a product orientation - was labeled "not a decisive factor." Thus, taxpayers are left in limbo about what would - or might - be required in other situations. An inescapable conclusion is that the Tax Court will allow the IRS more discretion in converting a taxpayer from the cash method than it will in overriding other accounting rules.(9)

(1) The Tax Court cited a number of decisions for this proposition. See Zaninovich v. Commissioner, 616 F.2d 429, 435 (9th Cir. 1980), revg 69 T.C. 605 (1978); Osterloh v. Lucas, 37 F.2d 277, 278 (9th Cir. 1930), aff'g 13 B.T.A. 713 (1928); Hillsboro National Bank v. Commissioner, 460 U.S. 370 (1983).

(2) In holding that "some distortion may be permitted," the court approved an accounting method under which the spread between the payment of commissions and the receipt of income could range up to 11 months for one product and 23 months for another.

(3) Although the economic performance standard was not effective for the years at issue in this case, the court pointed out the service had been performed.

(4) Announcement 83-131, 1983-32 I.R.B. 31.

(5) Prop. Reg. [sub-section] 1.451-3(g)(7), 1.452-1(m).

(6) Interestingly, the IRS did recast the regulations so that, technically, LIFO is not prohibited. The final regulations allow a modified LIFO method applied on an end-of-year basis. Thus, having been chastened for denying taxpayers their statutory right to use LIFO, the IRS apparently hopes the regulations will be interpreted as policing, rather denying, the use of LIFO. Because the Congress has drastically curtailed the availability of the completed contract method, however, the IRS's strategy in the LIFO/CCM situation may never be tested.

(7) In a concurring opinion, Judge Wells upbraided the IRS, saying that section 446(b) authorizes the Commissioner to require accounting changes that produce clearer reflection of income, not greater distortions of income.

(8) The court in SoCal cited Erwin Properties, Inc. v. Commissioner, 43 T.C. 888 (1965), on the deference to be given to the consolidated return regulations, but Judges Gerber and Cohen, in dissent, were not impressed. Judge Gerber complained that the majority erred in basing its decision on Treas Reg. [section] 1.1502-76 "which is essentially procedural in nature, to permit possible avoidance of a statutory tax accounting requirement."

(9) This article has focused on the extent to which the courts will allow the IRS to override an accounting rule. A related question is the extent to which the IRS will be permitted to stretch an accounting rule. The final regulations on the economic performance requirement stretch the all-events test beyond the point the Tax Court had indicated it was willing to go. In Molsen v. Commissioner, 85 T.C. 485 (1985), the Tax Court said the all-events test should not be distended to apply in determining the components of cost of goods sold. Nevertheless, the recently issued regulations appear to expand the all-events test well beyond its function of determining the timing of expense deductions. See Treas. Reg. [section] 1.461-4. The courts may decide the regulations under 461(h) are out of harmony with the purpose of the statute.

Larry Maples is a Professor of Accounting at Tennessee Technological University in Cookeville, Tennessee. He is a certified public accountant and holds a doctorate in business administration. He has contributed frequently to The Tax Executive, most recently in the March-April 1992 issue.